A Post-Keynesian perspective of money, financial intermediation and systemic instability
I t’s at the same time amazing and disturbing that mainstream introductory economics textbooks still teach fractional reserve banking and the money multiplier. Undergraduate students, myself included when I was an undergrad, learn that banks operate as intermediaries between savers and borrowers. If you are lucky enough not to have to spend all of your income, you deposit that unused income in a reputable bank. The bank in turn loans out those deposited funds to someone else at a profitable rate of interest. By loaning out your unused funds, this creates a multiplier effect by which the borrower spends the money which becomes someone else’s income, and so on. This assumption is crucial to monetarist theory. Banks are merely intermediaries between savers and borrowers; thus it is assumed that the money supply can be directly controlled using the interest rate policy by the Federal Reserve. The only new money that can enter the system is through the government. A low interest rate policy by the Fed can increase demand for money loans, increasing the money supply. Reducing the rate would do the opposite. Government spending into the economy either by direct fiscal expenditure or injection of reserves into the banking sector would increase the money supply causing inflation from “too much money chasing too few goods” as Milton Friedman would say. Friedman argued that inflation could be stabilized by controlling the money supply through the interest rate; which exposed his ignorance to how money is actually created in the economy.
Milton Friedman’s monetarism was based on the quantity theory of money which made two erroneous assumptions: (1) The growth rate of the money supply is the fundamental source of inflation, and (2) the supply of money is exogenous. For the first assumption to be true, the economy would need to be operating at full capacity and employment such that any increase in the money supply would increase demand beyond supply. For the second assumption to be true, banks would have to be constrained by the amount of deposits they have and the money supply could be controlled by manipulating the interest rate. As it turns out, banks do not need deposits to make loans to borrowers.
In reality, money does take the form of deposits, but banks are not limited by the amount of deposits they have in order to make a loan to a borrower whether a business or individual(s). This fact has been known for decades. The most prominent case is Joseph Schumpeter who wrote in 1954, “It is much more realistic to say that the banks ‘create credit,’ that is, that they create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them.” When banks make a loan they create two simultaneous entries on their balance sheet: one on the liability side in the form of a demand deposit for the borrower, and one on the asset side for the repayment of the loan by the borrower. Thus, loans create deposits, i.e. money, increasing the money supply. Many others that would follow Schumpeter such as Hyman Minsky, Nicholas Kaldor, Basil Moore, and other would further develop what has come to be known as endogenous money.
If the Federal Reserve is not the only source of money creation economy, then what tools does the Fed have to constrain the money supply? The Fed does controls the reserve requirement ratio. The reserve requirement is the ratio of vault cash plus reserves relative to deposits the bank has on the liability side of its balance sheet. The required reserve ratio has remained at 10 percent of deposits for many years. This means that when a bank creates a deposit, it does have to meet this requirement ratio by increasing the reserves in their Fed account by 10 percent of the amount of the loan deposit or cash on hand. Banks have several options to meet this requirement: (1) Banks can increase cash deposits or reserves by attracting new customers; (2) borrow money from other banks at the Federal Funds rate; and or (3) borrow funds directly from the Fed at the discount window. Option (1) is the cheapest for them, so banks offer services and small interest benefits on deposits to attract customers. Option (3) is the most expensive for them.
Alan Holmes, former vice chair of the New York Federal Reserve Bank, remarked,
The idea of a regular injection of reserves-in some approaches at least-also suffers from a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand… (Homes, 1969; emphasis added).
There is some dispute among proponents of endogenous money as to just how the Fed “accommodates that demand,” but most recognize that one way or another banks do find the reserves they need and focus very little on the reserve requirements. Bennett and Peristiani (2002) find that “reserve requirements have declined significantly in effectiveness, in the sense that they no longer appear to be as important a binding constraint on banks’ holdings of assets that qualify as reserves”. Thus, banks manage their reserves less to comply with regulatory minimums than to meet business needs and consumer demand, chasing reserves as they need them.
The Fed also uses the Federal Funds rate. While the interest rate does influence demand for loanable funds, the fundamental determination of whether the bank will make the loan is the creditworthiness of the borrower and the general state of the economy. But the Fed does control, for the most part, over the Federal Funds rate which is the overnight interest rate at which banks loan to each other. The Federal Funds rate does influence the relative interest rate banks ultimately charge to make loans to consumers and businesses, and thus the growth rate of the money supply; however, it is not a direct control mechanism. Pollin (2008) finds some evidence of a causal relationship between the Federal Funds rate and market rates in the short-term, but no significant correlation in the long-term. Market forces, instead, appear to be “a major force-and are in most cases the major determinant-of market interest rates, especially at the long end of the markets”. Which means that to an extent, even market interest rates are endogenous to the financial system.
Today, the Fed strives to target interest rates rather than monetary aggregates, but is not capable of “fine-tuning” as many believe. It is capable of “gross-tuning” meaning that changes in the Federal Funds rate can influence to some extent market interest rates. The Fed has proven it can exert moderate influence on long-term rates through its unconventional quantitative easing program by purchasing long-term bonds and assets, including mortgage backed securities guaranteed by the Federal government. But the more important function the Fed plays is the lender of last resort. The Fed proved how important this function was during the Great Financial Crisis of 2007–08. As commercial banks such as Bear Stearns, and some non-bank financial institutions such as AIG, found themselves in a liquidity crisis, the Fed stepped up, through intermediaries in some cases, with additional funds. Additionally, the Fed facilitated buyout arrangements which, while producing some moral hazard concerns, likely prevented a prolonged credit freeze which might have resulted in a more severe recession or a depression.
I have used the term endogenous money to describe the process of above by which banks create money through loans. However, since this endogenous expansion of the money involves extending credit, endogenous finance might be just as appropriate; especially when speaking of more complex financial assets.
Money serves three important functions: (1) a means of exchange; (2) a unit of account, and (3) a store of value. Any asset that exhibit these characteristics bears a degree of “moneyness.” More narrow measures include only the most liquid assets, the ones most easily used to spend in the economy such as currency, demand deposits, etc. Broader measures add less liquid types of assets such as certificates of deposit, savings deposits, small time deposits, and retail money market mutual funds; each of these being a financial innovation at one point in history. According to Pollin (2008),
Innovation is a persistent feature of financial markets practices…Innovation in financial markets are primarily driven by efforts to enhance both the liquidity and store of value functions of any given financial asset, such as a Certificate of Deposit, a credit derivative, or securitized mortgage. Basically, this means lowering the costs of converting relatively high-yielding illiquid assets into liquid assets.
To the degree that these financial innovations exhibit “moneyness,” measures of the money supply (e.g. M1, M2, M3, etc.) need to become more sophisticated and inclusive to better understand the impact on the economy. However, financial innovation bears two contradictory tendencies: (1) It relaxes the “saving-constraint,” and (2) it increases financial fragility. I will discuss both of these in turn.
The mainstream view assumes that investment, and consumption for that matter, is constrained by savings. In this view, banks operate merely as intermediaries between savers and borrowers, investment and consumption cannot exceed the available amount of savings in the economy. The economy is “self-financed” and thus “savings-constrained.” Once one accepts the endogenous money view, it becomes immediately evident that savings becomes less of a constraint. Thus, banking institutions themselves are a financial innovation which relax this constraint since loans create deposits and increase the money supply. As more complex financial institutions and innovations introduce new forms of financial intermediation, the savings constraint becomes more and more relaxed. As put succinctly by Pollin (1997):
Financial intermediation is the process whereby market participants, private institutions, and governments act to reduce information and transaction costs of financial provisioning, as well as allow for diversification of the risks associated with such activities. All else equal, reducing costs and diversifying risks through intermediation implies both that interest rates and collateral requirements on loans should fall in conjunction with declining costs of the diversification of risks. Financial innovation, in turn, is the process in which market participants create new channels and techniques of intermediation. In particular, asset and liability management techniques devised by intermediaries have created thick markets for liquidity.
As we introduce more complex financial institutions (e.g. mutual funds, shadow banking system, etc.), government functions of financial intermediation (e.g. Federal Funds market, treasury securities, Bond sale and Repo market, etc.), and foreign financial intermediaries, information and transaction costs tend to come down, risk becomes more diversified, and more liquid assets are created weakening the “saving-constraint” through greater credit availability. The government especially plays a unique role here as it is the only institution that can create an exogenous injection funds into the economy. While every dollar produced is a liability on the government’s balance sheet, it bears no inherent default risk. To the extent that the government “finances” its injections as conventionally believed it needs to do, “it broadens its role as a financial intermediary,” and “creates further possibilities for the allocation of liquid assets” (Pollin, 1997). Government monetary institutional structures, regulatory regimes, and monetary policy shape the development of financial innovation; which also means that such innovation and structural complexity will vary across economies. Additionally, regulatory structures and general market conditions vary over time, and thus the innovation and structural changes in financial markets are also likely to vary over time. This means that the savings-constraint itself is likely to be variable over time. Pollin further points out, as any system grows in complexity, the innovative financial products and institutional structures tend to become permanent even when the conditions that produced them revert to normal states. This permanents builds on complexity in each era of innovation which contributes to financial fragility. This brings us to the negative tendency of financial innovation.
The government has the unique role of regulating financial intermediation. Pollin (2008) notes, “the effects of [financial innovation] on market outcomes increase as the degree of market regulation declines.” As noted above, given permanent tendency of structural change, regulatory regimes are crucial to ensure a sound financial system. “Normal unregulated financial market practices inherently generate states of systemic instability, as financial market participants, operating to maximize profit under conditions of uncertainty, systemically assume riskier financial positions as cyclical expansions proceed”.
The Neoliberal era has been marked by a dogmatic view of financial liberalization and deregulation. This was more or less the conventional wisdom in US leading up to the Financial Crisis of 2007–08. In his book, How Markets Fail, John Cassidy chronicles the deregulation of Wall Street for which Alan Greenspan was a central figure. “During the 1990s, he [Greenspan] played a key role in the dismantling of the Glass-Steagall Act, the Depression-era legislation that prevented depository institutions, such as Citigroup and Wells Fargo, from taking part in investment banking activities, such as peddling stocks, bonds, and mortgage securities”. Greenspan would go on to encourage the near full repeal of Glass-Steagall with the Gramm-Leach-Bliley Act of 1999. As derivatives came into prominence in the 1990s, “Greenspan, along with the Treasury, called on Congress to bar the CFTC [Commodity Futures Trading Commission] from regulating credit default swaps and other derivatives-a proposal that was passed into law the following year”. This is not to say that had all these prior regulations stayed in place that the financial system would not have been susceptible to system risk, but rollbacks in regulation opened the floodgates for rampant financial innovation and overleveraging in financial markets which undisputedly contributed to the Financial Crisis.
Bennett, Paul and Peristiani, Stavros (2002). “Are U.S. Reserve Requirements Still Binding?” Economic Policy Review, Volume 8, Number 1.
Cassidy, John (2009). How Market Fail: The Logic of Economic Calamities. New York, NY: Picador.
Holmes, Alan (1969). “Operational Constraints on the Stabilization of Money Supply Growth.” Controlling Monetary Aggregates. Conference Series №1. Federal Reserve Bank of Boston.
Pollin, Robert (1997). The Macroeconomics of Saving, Finance, and Investment. Ann Arbor, MI: University of Michigan Press.
Pollin, Robert (2008). “Considerations of Interest Rate Exogeneity.” Draft, August, 2008.
Schumpeter, Joseph (1954). History of Economic Analysis. New York, NY: Oxford University Press